The decision to take control of your financial future by trading the markets is exhilarating and liberating. But there are many decisions left to be made, including market selection and the desired holding period. The single most important decision may be trading style: How the trader will select and execute trades. The two most common methods are discretionary and mechanical, or system-generated.
Many traders struggle with discretionary trading because of its inherent flexibility and subjectivity, which provides too much room for emotion-driven decisions. Conversely, others struggle with using purely mechanical, automated systems because of their rigidity and complexity.
There is a third option that often is overlooked: Probability-based trading. With the widespread adoption of spreadsheet applications such as Excel and the proliferation of reliable, intraday data, traders can avoid many of the pitfalls of discretionary and systematic methodologies, while enjoying the advantages of each. Here, we’ll explore the pros and cons of these two approaches and demonstrate why a hybrid approach built around probability-based execution may be the optimal method for many retail traders.
The discretionary trader
The discretionary trader can make decisions based on fundamentals, technicals or a combination of both. He can make trade decisions based on the interpretation of price charts using indicators and price patterns but does not have hard and fast rules based on price action. This approach is appealing because it provides a sense of control that is attractive to many. Other benefits include:
- Easy to learn the basics
- Freedom and flexibility to adjust each trade as needed
- Appeals to the independent nature of many traders
Though the feeling of control attracts most traders, it is the randomness of success that entraps even the most astute individual. It is widely accepted that the vast majority of self-directed traders use discretionary techniques and that more than 90% of them fail. Many believe that it is because of poor money management. And while true, poor money management is often a byproduct of false expectations regarding the ease and speed of achieving consistent success.
With positive and perhaps naive expectations, the new trader easily confuses winning trades with skill, and losing trades with bad luck. Worse, the laws of probabilities can conspire to paint an extremely misleading picture.